Chapter 4: Preparing Financial Statements
- 1 Learning Objectives
- 2 4.1 - Purpose of Financial Statements
- 3 4.2 - Fundamental Qualitative Characteristics of Financial Statements
- 4 4.3 - Financial Statement Headings
- 5 4.4 - Income Statement
- 6 4.5 - Statement of Owner’s Equity or Statement of Retained Earnings
- 7 4.6 - Balance Sheet
- 8 4.7 - Statement of Cash Flows
- 9 4.8 - Financial Statement Footnotes
- 10 4.9 - Summary of Accounting Information Flows
- 11 4.10 - Comprehensive Example Using A Financial Statement Preparation Worksheet
- 12 4.11 - Standardization of Accounting Principles
- 13 4.12 - Extensible Business Reporting Language (XBRL)
- 14 4.13 - Financial Reporting Process
- 15 4.14 - The Role of Financial Statement Auditors
- Learn about the qualitative characteristics of financial statements
- Learn about the importance of the income statement
- Learn how to prepare an income statement
- Learn about the importance of statement of retained earnings
- Learn how to prepare the Statement of Retained Earnings
- Learn about the importance of the balance sheet
- Learn how to prepare a balance sheet
- Learn about the importance of the statement of cash flows
- Learn how to prepare the statement of cash flows
- Learn about GAAP, XBRL, the financial reporting process and the role of financial statement auditors
4.1 - Purpose of Financial Statements
A financial statement is a standardized set of accounting documents. Accounting information is summarized in a standardized manner in order to encourage comparability of the documents. There are 4 different types of financial statements: the balance sheet, income statement, statement of retained earnings, and statement of cash flows. Depending on the reporting framework used, proper footnote disclosures will be required along with a management discussion and analysis (MD&A) section. The MD&A section of the financial statements is a document that accompanies the financial statements where management discusses significant business information.
Overall, the primary purpose of financial statements is to report financial information about an entity to external users of the financial statements. Internal users can also use financial statements but management generally will have better information available through ad-hoc (custom) management accounting statements. In order for financial statements to be useful they must follow a specific set of characteristics which we call fundamental qualitative characteristics.
4.2 - Fundamental Qualitative Characteristics of Financial Statements
The accounting standards establish two fundamental qualitative characteristics for financial statements: relevance and faithful representation. Additional enhancing qualitative characteristics improve the overall quality of the financial statements. Relevance is composed of three characteristics: predictive value, confirmatory value and materiality. Faithful representation is composed of being complete, neutral and free from material error. The enhancing qualitative characteristics are verifiability, comparability and timeliness.
Relevance: The financial statements should include all relevant facts or information. Information is considered relevant if it will have an impact on a user's decision. Information can be considered relevant even if the user decides not to act on that information. For information to be relevant it must have the following three characteristics of predictive value, confirmatory value and materiality.
- Predictive Value: Information has predictive value if that information can be used to predict future events. The information does not need to be a prediction, rather, the information is used as an input for financial statement user's own predictions.
- Confirmatory Value: Information has confirmatory value if that information is able to validate financial statement user's past predictions. It is important to note that predictive value and confirmatory value are linked to each other. Information can have predictive value and confirmatory value. For example, net income data can be used to predict future net income amounts or it can be used to confirm past predictions that were made about the current period's net income data.
- Materiality: Information is material if it has the ability to influence or change a financial statement user's decision about the entity if that information is omitted or misstated. Materiality varies from entity to entity. Smaller entities will have a lower materiality threshold while larger entities will have a higher threshold. The data should also be considered in aggregate. A low dollar error will not breach the materiality threshold but if that same error is repeated ten million times then it could become a material error that should be reported or disclosed. Professional judgement must be used to determine what is material.
Faithful Representation: Financial statements represent an aggregation of business events and transactions in a summarized format. In order for financial statements to be useful, they must faithfully represent those business events and transactions. To faithfully represent those transactions the financial statements need to be complete, neutral and free from material errors.
- Complete: Financial statements are said to be complete when they include all facts and information necessary for a user to be able to understand the business events and transactions of the entity. In order to achieve this goal, the financial statements must include not only numerical summation of transactions but also include any written descriptions. For example, a group of assets would need to include a description of what assets are in the group, the value of those assets and what basis those assets are valued at (historical cost, fair value etc.). Any additional information needed to understand the business assets or transactions should also be disclosed, especially if those facts are not able to be represented in a numerical form.
- Neutral: The financial statements should be free from bias. Information and facts presented in the financial statements should be presented in the most truthful manner possible. The information should never be presented in such a manner that it either presents the information in a favorable or unfavorable point of view.
- Free from Material Error: The financial statements should be free from any errors that would change a user's decision. Minor errors are acceptable as long as those errors are not intentional. An error is considered material if that error alone or in aggregate would cause a user to change their decision. A material error does not simply mean an error in a numerical value. A material error could also include an essential description of facts that are not disclosed with the financial statements.
Enhancing Qualitative Characteristics of Financial Statements
- Verifiability: Verifiability means that information can be verified by independent sources. What this means is that two independent and knowledgeable individuals should be able to reach the same consensus given the same set of facts or data. Verification can be through direct observation or through indirect methods, such as, through the use of a model. Not all information will be verifiable because that data can only be verified in the future. When such circumstances exist, the assumptions, methods and circumstances should be disclosed that were used to create that information.
- Comparability: Comparability means that information is more useful when it can be compared with similar information from other entities. Information is also more useful if that information can be compared with information from the same entity from different dates. This allows for trends and forecasts to be created or comparisons to be made.
- Timeliness: Information is only useful when it is available during the time when the user is likely to make their decisions. For example, users will need to have the most up to date financial information in order to make investment decisions. The more recent the information, the more useful it is. As time goes by, the information becomes less useful.
- Understandability: Information must be understandable by users in order to be useful. To achieve understandability the information will need to be classified, characterized, and presented clearly and concisely. We assume that the user has a reasonable knowledge of finance or accounting to understand the accounting information.
Pervasive constraint of cost vs benefit: Accounting information requires a cost that will be realized by the entity preparing the accounting information. Accountants and bookkeepers all must be paid a certain amount for their services. As a result, the accounting standards recognize that not all accounting information will be able to be presented in the financial statements. The basic assumption is that all costs must be justified by the benefits obtained from the information.
4.3 - Financial Statement Headings
All financial statements must have a standardized heading to clearly indicate what the financial statement is reporting. There are three primary elements that each financial statement must have:
- Entity Name: The entity name must be clearly written at the top of the financial statement to indicate which entity the financial statements are reporting.
- Name of the Financial Statement: Each financial statement must clearly indicate which type of financial statement is being presented. For example, the title could be balance sheet, income statement, statement of cash flows or retained earnings statement.
- Time Period: Each financial statement must clearly indicate what time period the statement covers. Typical time periods covered are quarterly (3 month period) and annually (12 month period usually ending December 31st).
The following are examples of typical financial statement headings:
The term consolidated means that the company is combining financial information from smaller companies that they own. Also note that the balance sheet is reporting based on a single date. The term "Inc." seen in the entity name means the company is incorporated as a corporation.
As we can see above, this is a quarterly report for the 3 month period presented. The company has also chosen to present data for a 6 month period as well. Companies may choose to present whatever data they want as long as it follows standard accounting rules and is clearly labeled.
Statement of Cash Flows:
In the above statement of cash flows, the company reports the date as "three months ended March 31st." This means the data being reported is for the first 3 months of the year.
4.4 - Income Statement
An income statement is an integral part of a comprehensive set of financial statements. The income statement reports revenue, expenses and net income/loss over a specific period of time, usually quarterly or annually. The income statement is often referred to as the P&L which stands for profit and loss. At its most basic form, the income statement shows how much revenue a company earned, how that revenue was spent and how much revenue was converted into net income (profit) or net loss. The income statement essentially displays the matching principle as it shows what revenue was earned for the period and the associated expenses for those revenues. The financial statements must be prepared in a specific order and that order is: income statement, statement of retained earnings, balance sheet and statement of cash flows. As we explain each statement, it will become clear why this order is important.
When creating an income statement, it is important to follow a specific set of guidelines. On the top of the statement should be the name of the business entity with the words "income statement" below it. Below the word income statement should be the period the statement reflects. If the statement is for one month then it would be labeled as, "For The Month Ended December, 2016". You begin the statement by listing revenues followed by expenses and finally net income or net loss. Under each category you should list the largest revenue and expenses first as measured in monetary units. The balances for each account come from the adjusted trial balance.
Displayed above is a basic income statement. As you can see, revenues are listed first followed by expenses and finally net income or loss. We can also see that largest revenues and largest expenses are listed first to show significance of those revenues and expenses. Once we have calculated net income for the period, we can allow that number to flow into our statement of retained earnings which we will create next.
Overall, there are two commonly used income statement formats: the single-step and the multi-step income statement.
Single-Step Income Statement: The single-step income statement is divided into two categories: revenue and expenses. Expenses are subtracted from revenue to calculate net income/loss for the period. This format of income statement is used less frequently compared to the multi-step income statement because it excludes detailed information about revenues and expenses. It also lumps together operating and non-operating expenses together which makes the information more difficult to understand. The income statement above is an example of a single-step income statement.
Multi-Step Income Statement: The multi-step income statement is the most popular format for income statement due to the additional information it presents. The multi-step income statement is divided into two major sections: operating section and non-operating section. The operating section lists revenues and expenses that are generated from the major operations of the business while the non-operating section lists revenue/expenses from other activities. Within the operating expenses section, expenses are subdivided into selling or administrative classifications. Overall, we begin by calculating gross profit (revenue - cost of goods sold) followed by subtracting operating expenses. We then list non-operating activities and then add or subtract that number to calculate income before taxes. The final number is net income which includes the effect of income taxes. The following is an example of a multi-step income statement:
We can also use a flow chart to help visualize the flow of information on the income statement.
As you can see, the multi-step income statement involves more steps and contains more detailed information. At this point, don't worry about the specific accounts used in the above income statement. Those accounts will be explained in detail in later chapters.
4.5 - Statement of Owner’s Equity or Statement of Retained Earnings
The statement of owner’s equity reports the increases or decreases in owner’s equity over a specific period of time. This statement may also be referred to as the statement of retained earnings.
Retained Earnings: Retained earnings are the profit the company has earned since it was formed after adjusting for dividends and any other forms of distributions to owners. It is calculated using the following formula: Revenue - Expenses - Dividends (paid in cash or stock) or Net income - Dividends
Dividends: Dividends are payments directly to shareholders. Dividends can be paid in cash or property but are generally paid in cash. The source of dividend comes from profits of the company (retained earnings). For the company, a dividend payment to shareholders is not considered an expense; rather, it is a return of after-tax profits to shareholders.
Net Income: Net income or profit is created when revenues and gains are greater than expenses and losses.
Net Loss: Net loss is created when expenses and losses are greater than revenue and gains.
As you can see, the net income from our income statement is flowing into the statement of retained earnings. An interesting observation can be seen here with the retained earnings account. We can see that we start with the beginning balance of retained earnings, add net income and then subtract dividends. In essence, the retained earnings account can be thought of as a savings account that flows from period to period. This is in contrast to the income statement accounts that only reflect revenues and expenses for a specific period. After the ending retained earning balance is calculated we can move on to preparing the balance sheet. The ending retained earnings balance is reported on the balance sheet.
4.6 - Balance Sheet
The balance sheet reports a company’s assets, liabilities and owner’s equity at a specific date (e.g. December 31st, 2018). If we can compare the balance sheet to the income statement and retained earnings statements, we can see that the income statement and retained earnings statement accounts seem to flow from period to period while the balance sheet is simply a snapshot of the company at a specific point in time. We can also see that the balance sheet is showing the company's assets and the claims against those assets (liabilities) with the end result showing the residual claim to those assets (owner's equity/stockholder's equity). The balance sheet may also be referred to as the statement of financial position.
Current Assets: Current assets are assets that the company expects to convert to cash or consumed within 12 months or one operating cycle, whichever is longer. In this case, the term operating cycle also needs to be defined. Current assets are ordered by liquidity with cash being the most liquid current asset. The operating cycle of a company is the amount of time it takes a business to spend cash on a business process, have the business process produce the good/service and convert those goods/services back into cash. For example, a bicycle company would spend money to purchase the raw materials to create the bicycles and then sell the bicycles for cash. The operating cycle is complete when the business has sold the bicycle and received cash. For certain companies, the operating cycle can exceed 12 months due to the time it takes to complete the operating cycle. For example, an airplane manufacturer might take several years to build and sell their airplanes. For the airline company, their current assets would exceed the standard definition of converted into cash within 12 months. Some examples of current assets are cash, accounts receivable and inventory. The general ordering of current assets is: cash, accounts receivable, inventory and prepaid expenses. The following are classified as current assets:
- Cash: Cash is coins, currency, checks, money orders, unrestricted bank deposits, and certificates of deposit (time deposits). Cash is often the first asset reported on the balance sheet because it is considered the most liquid asset.
- Accounts Receivable: Accounts receivable are current assets that are due from customers from past transactions where the business issued credit to the customer. This credit is often referred to as trade credit because it is short-term and helps to facilitate transactions with repeat customers. The amount shown in an account receivable is the amount that is due from customers. Accounts receivable are removed from the balance sheet when the customer has paid the receivable in cash or the business has written them off as uncollected bad debts.
- Marketable Securities: Marketable securities are stock or debt securities that the firm owns. Marketable securities are classified as a current asset if the management team intends to sell them within 12 months. Marketable securities are able to easily be bought or sold relatively quick and are considered an asset class with high liquidity.
- Interest Receivable: These assets represent interest that is owed to the company (as a result of the passage of time) but has not received the interest from the borrower. Interest receivable accounts are often setup for loans where the interest is paid in periods that exceed 1 month. For example, if interest is paid to the company every three months then an interest receivable account will be setup to record the interest that has accumulated from month two until the time it is paid in month three.
- Advances to Suppliers: These assets are created when the business advances cash for goods or materials that will be delivered in the future. The cash paid in advance is recorded as a current asset until the goods are received.
- Prepaid Rent: Prepaid rent is when the business pays their rent (to the landlord) in advance. For example, the rental agreement might require the business to prepay their rent 6 months in advance. The prepaid rent is considered a current asset because it will provide a useful benefit to the company within the next 12 months.
- Prepaid Insurance: The insurance company will often sell insurance plans that cover the next 12 months. The business will pay for the insurance in one lump-sum payment beginning in the first month.
Non-Current Assets: Non-current assets are any asset that is unlikely to be converted to cash within 12 months. Non-current assets may also be referred to as long-term assets. The following are typical non-current assets:
- Long-Term Investments: Long-term investments are assets that aren't expected to be converted into cash within one operating cycle or within 12 months, whichever is longer. Investments could be for securities, land, buildings, equipment, furniture, fixtures or any similar assets.
- Accumulated Depreciation: Depreciation is the accounting entry used to record an asset wearing down over time. For example, a car might only be useful for 20 years. In order to properly reflect this degrading of value as the vehicle is used, the loss of value is recorded as depreciation. Accumulated depreciation is the amount of depreciation that has been recorded over the asset's life time. Depreciation is a significant topic in accounting and it will be covered extensively in later chapters.
- Notes Receivable: A note receivable is similar to traditional short-term credit except that notes receivable are generally repaid over a period longer than 12 months. Due to the long-term nature of the receivable, these types of receivables are recorded between the lender and creditor using a note. A note is a legally binding document that explains the terms of the credit agreement. A short-term account receivable is rarely recorded using a note.
Capital Assets: A capital asset is any asset that will be held for longer than 12 months and will not be sold in the ordinary course of business. Examples of capital assets include equipment, land, buildings, office computers and vehicles.
Property, Plant & Equipment (PP&E): Property, plant & equipment are fixed assets which are generally unmovable and not intended for immediate sale. Some examples of property, plant & equipment are factory buildings, office buildings, construction equipment, large factory machines and vehicles. Most PP&E is classified as capital assets.
Intangible Assets: Intangible assets are assets that are not tangible (you cannot touch it) and are generally noncurrent assets. Some examples of intangible assets are patents, copyrights, trademarks, trade secrets or customer lists.
Current Liabilities: Liabilities that are expected to be satisfied within 12 months or the operating cycle whichever is longer. Examples of current liabilities are accounts payable, short-term debt and taxes payable. Current liabilities are significant because they will often use current assets (i.e. cash) to pay them. If the company does not have enough current assets available to meet current liabilities then the company could have financial troubles due to a lack of liquidity.
- Accounts Payable: Accounts payable are short-term and informal (not recorded using a note) forms of credit used to facilitate trade. The accounts payable is a liability because cash or other assets must be used to pay to another business. For the business receiving the money they have accounts receivable on their balance sheet. When a company makes a purchase using an account payable it is referred to as buying on account.
- Interest Payable: If a company issues bonds or other forms of debt securities then the company must pay interest periodically to the owners of the debt. Any amount of interest that is payable in the future as interest would be classified as interest payable.
- Income-Tax Payable: If a business is liable for income taxes, they will record their unpaid income tax liability by setting up an account payable called income-tax payable.
- Customer Advances: If a customer pays the invoice before the service/goods have been performed or shipped then the business will record the cash as a customer advance. When the business has performed the service or shipped the goods then the business will transfer the advance into a revenue account.
- Rent Advances: Similar to a customer advance except for rent. If you are an owner of real estate and your tenants pay their rent in the form of a prepayment then this rent will be recorded as a rent advance. The rent is only recorded as rental income when it has been earned.
Long-Term Liabilities: Long-term liabilities are liabilities that are not due within 12 months or one operating cycle, whichever is longer. A good example of long-term liabilities is a mortgage (note payable used to buy real estate) which are generally for 30 years. A unique feature of long-term liabilities is that the current portion of the liability must be classified as current. Assuming a less than 12 month operating cycle, if we had a 30 year mortgage note then 29 years would be classified as a long-term liability while 1 year of the liability would be classified as current.
- Notes Payable: Notes payable are long-term liabilities that are recorded using a note. A good example of a note payable is a mortgage that is used to buy real estate. A significant aspect of a note payable is that the liability must be classified into current liability and non-current liabilities. All payments that are going to be made in the next 12 months are classified as current liabilities while any payments that occur greater than 12 months must be classified as non-current liability.
- Bond Payable: A bond is similar to a note payable expect the bond is created by using an indenture. Bonds are different from notes payable by the amount of entities or individuals the money will be borrowed from. A note payable is borrowed from one individual or entity while a bond is borrowed from multiple entities. The total amount of the bond is broken up into smaller securities. For example, a $1,000,000 bond can be broken up into 100 bonds worth $10,000 each which allows for smaller investors to help finance the bond. For especially large bond issues, the bonds are often sold on national securities exchanges and can be traded like stocks.
- Deferred Income Taxes Payable: This account is used for income taxes that will be payable in the future. For example, a business might have a settlement agreement where a past income tax debt will be paid in 10 equal payments over the next 10 years.
Owner’s Equity or Stockholder's Equity: Simply put, owner's equity is the residual claim to the assets after all liabilities have been paid off. Depending on the type of business entity (proprietorship, corporation, partnership etc.) different items will show up in the owner's equity section. For proprietorships, the owner's investment will be called owner's capital and the owner's distributions will be called owner's drawing. For partnerships, each partner (partial owner of the partnership) will have a separate account for their respective capital and withdrawals (distributions). For corporations, the owner's capital will be called common stock (or other similar type of securities) and distributions will be called dividends.
Stockholder's equity is calculated as follows:
Stockholder's equity = Investments by owners/stockholders (common stock) - Distributions of Earnings (dividends) - Net income/loss (revenue - expenses)
The following are typical stockholder's equity accounts:
- Common Stock (par value): This account represents the amount of capital contributed equal to the par value of the stock. All stock must have a stated value, call the par value. Any amounts contributed that are in excess of the par value is accounted for using the additional paid-in capital account. Most companies issue their stock at a rate of $.01 (one penny) to make sure that most of the capital is allocated to the additional paid-in capital account. The par value of the stock has no relation to the market value of the stock.
- Additional Paid-in Capital (APIC): This account represents capital that has been paid for new shares of common stock that are in excess of the par value. This account may also be referred to as "capital paid in excess of par." This account shows the aggregate amount of APIC from all investors rather than a single investor.
- Preferred Stock: A company issues this type of security which has special privileges over regular common stock. Usually the privileges include the right of receiving dividends before common shareholders. If a dividend is declared and not paid then the preferred stock will be able to collect prior dividends when new dividends are paid. These dividends are called dividends in arrears. Preferred stock can also have disadvantages, for example, it is common for preferred stock to have no voting rights. The specific attributes of preferred stock are declared when they are issued.
- Retained Earnings: Retained earnings is the amount of increase in net assets since the firm's creation. The retained earnings will increase by profitable operations of the business, when revenues exceed expenses. The formula to calculate retained earnings is net assets - net liabilities. The best way to understand retained earnings is to think of it like a savings account. Retained earnings will increase when earnings are greater than any dividends you pay. If you earn $1,000 and pay $700 dividends (in cash or property) then your retained earnings account will increase by $300. Retained earnings represents assets that can be used to pay future dividends or used for other purposes, such as, reinvesting in the business. The retained earnings account does not represent an asset. Rather it simply shows the amount of earnings a company has had that was not paid out as a dividend.
- Accumulated Other Comprehensive Income (AOCI): AOCI is a very complicated account that is generally taught in more advanced accounting courses. To simply put it at this point, AOCI is used for recording changes in net assets that do not affect net income. The changes are recorded on the balance sheet until the changes are realized. Once they are realized the balance sheet account is adjusted and the realized transaction is recorded on the income statement.
Below is a typical balance sheet:
As we can see above, the balance sheet is organized by asset, liability and stockholder's equity sections. It is important to note that the statement above is for a corporation since we have a stockholder's equity section. If this statement was for a private entity then the stockholder's equity section would be called owner's equity. Also note that this statement is dated December 31st, 2016 and the amounts shown are the amounts that were valid for that date. If we were to make the statement for December 30th, 2016, the amounts listed might be different depending on the activity of the company. The asset section is grouped by liquidity which means the ability to quickly convert into cash with insignificant amount of loss. As you can see, cash is the most liquid with accounts receivable being second. Accounts receivables can be quickly converted into cash by selling them to a factor. A factor is a company that pays cash for accounts receivable and attempts to collect those accounts. Buildings are the least liquid asset because it takes a substantial amount of time and effort to sell buildings. The liabilities section is listed in order of maturity. Current liabilities (such as accounts payable) are listed before noncurrent liabilities (note payables). The reason for this ordering is quite intuitive as well. Just imagine if you are an investor in this company. You would want to know what debts and what amount of debt is due. If a company has a large amount of current liabilities then that could mean the company is in financial trouble. Large amounts of long-term debt will be less of an issue due to the fact that noncurrent liabilities are repaid over 1 year or longer. Current liabilities are always listed before noncurrent liabilities. The current portion of noncurrent assets are listed as a separate account under current liabilities (i.e. current portion of note payable).
Another important feature of the balance sheet is that it is organized to follow the accounting equation, Assets - Liabilities = owner's equity. Thus, if we subtract the net assets by the net liabilities we should always equal the amount of net owner's equity. Using the balance sheet above, we can see that we have net assets of $737,000 and net liabilities of $185,000. If we subtract the net liabilities from the net assets it equals $552,000 which is the amount of our net stockholder's equity. We can also see that net liabilities and net stockholder's equity equals net assets, which is essentially a different way to represent the accounting equation: assets = liabilities + stockholder's equity.
The stockholder's equity section lists common stock and retained earnings. Contributed capital (common stock) is listed before retained earnings.
There are a variety of formats for the balance sheet, the most common variants are the following:
- Report Form: A report form balance sheet lists the balance sheet accounts in a vertical format with asset, liabilities and owner's equity being presented as titles in the balance sheet.
- Account Form: An account form balance sheet reports assets on the left side of the form while liabilities and owner's equity are presented on the right.
- Classified: A classified balance sheet classifies the accounts based on classifications such as: current assets, long-term investments, fixed assets, intangible assets, current liabilities, long-term liabilities, and shareholder's equity. A classified balance sheet can also be classified based on current or long-term aspect of the account. The additional subgroups allow users to better understand the financial structure of the company.
- Common Size: A common size balance sheet lists all assets, liabilities and owner's equity in the form of numeric values as well as a percentage of the overall section.
- Comparative: A comparative balance sheet will list balance sheet data based on multiple points in time. For example, a comparative balance sheet could list the December 31st, 2017 amounts next to the December 31st, 2018 amounts.
4.7 - Statement of Cash Flows
The statement of cash flows reports the cash inflows and cash outflows of the entity over a specific period of time. Simply put, it shows where a company generates its cash and how that cash is used. Out of all the financial statements, the cash flow statement is prepared last. The statement of cash flows is organized into three major sections: operating activities, investing activities and financing activities.
Operating Activities: Lists cash inflows and outflows that are generated from the company's primary business operations.
Investing Activities: Lists cash inflows and outflows from investments (i.e. purchasing land, selling buildings, buying equipment etc.).
Financing Activities: Lists cash inflows and outflows from buying/issuing bonds, selling common stock, and paying dividends.
The statement of cashflows would be useful for evaluating the credit worthiness of a company or could be used by investors to determine if the company is going to have a cashflow problem in the future. If a company is having a short-term cash flow issue it might mean the company would need to borrow more money or make asset sales to raise cash. The statement of cashflows final line is the net change in cash for the period. This line can be used to verify the overall accuracy of the statement by adding the beginning cash balance with the change in cash for the period and verifying it to the cash balance.
4.8 - Financial Statement Footnotes
All financial statements must abide by the full disclosure principle. This principle states that all material (significant) facts must be disclosed. For most facts the information can be disclosed through the financial statements. For other facts, they need to be disclosed through writing and organized into information that is useful for the financial statement users. These visual charts and written statements are called the notes to the financial statements.
The notes to the financial statement are so significant that they are considered an integral part. Without the notes to the financial statements it would be wise to conclude that the financial statements are misleading. For a financial statement user, the notes to the financial statements could contain information that is just as valuable as the quantitative figures presented in the financial statements.
For all areas of the business, key information must be disclosed in the notes to the financial statements. The financial reports will be required to disclose the accounting methods used to prepare the financial statements in a section called "Summary of Significant Accounting Policies". As you progress through this course, you will learn about various methods you can use to prepare different sections of each financial statement. The method you use must be disclosed in the notes. For all other areas of the financial statements, key information must be disclosed, such as, inventory method used, types of securities owned by the company, pension obligations, debt obligations as well as many other key pieces of information.
4.9 - Summary of Accounting Information Flows
The following diagram shows the flow of data from one financial statement to the next. As you can see, we begin by preparing the income statement to calculate our net income. The net income then flows to the retained earnings statement which is prepared after the income statement. Our retained earnings are calculated and then flows to the balance sheet. The total amount of cash at the end of the year flows to the statement of cash flows. It is impossible to prepare the financial statements in a different order due to the flow of information from one financial statement to the next. If the financial statements do not articulate (agree with each other) then it is a sign that the financial statements are not correct and should not be used to make financial decisions.
4.10 - Comprehensive Example Using A Financial Statement Preparation Worksheet
Worksheets are tools used by accountants that are used to help prepare financial statements as well as other accounting information. The worksheet we will be using in this example is used to prepare financial statement account balances based on the overall accounting cycle. We begin with the trial balance and move through the cycle ending up with the amounts required to be reported on the income statement, statement of retained earnings and balance sheet.
The following is a completed worksheet used to calculate adjusting entries, financial statements and closing entries. The following chart looks very confusing at first glance but it flows very logically once you understand what is going on. It also serves as a nice review for how the flow of accounting information works.
Now that you've reviewed the above information, let's review exactly what is going on. We start by obtaining the trial balance from each account in the general ledger and place the amounts in the respective columns. We then move on to making sure that the debits equal the credits for the trial balance column. We further move on to applying our adjusting entries. In this case, the adjusting entries were as follows:
- $25,000 of service revenue was earned
- Recorded salaries expense of $4,000
- $2,500 worth of depreciation was recognized (deprecation will be fully covered in future chapters). At this point, you should know that depreciation is simply a way of recognizing the decline in value of an asset being used.
- $2,000 worth of interest was accrued and recognized as an expense.
We finish the adjusting entry column by making sure the debits equal credits for the column. Our next column is the adjusted trial balance. For the adjusted trial balance, we start with the amount in the trial balance and apply the effect of the adjusting entry. To properly perform these calculations, you need to know the normal balance of the account and understand what effect a debit or credit will have on the account. The column is completed by making sure that debits equal credits. At this point, we are now ready to prepare our financial statements. For each account, you must know where that account is reported. Assets, liabilities and equity are reported on the balance sheet. Revenues and expense are reported on the income statement and retained earnings + dividends are reported on the statement of retained earnings. For each account, determine where the account will be reported. Once that is completed, it starts to get tricky.
Let's start with the income statement. With the income statement, you'll notice that the debits and credits do not balance. We have $36,500 debit and $56,000 credit. Upon closer inspection, we can see that we have $56,000 revenue and $36,500 expenses. We can use the difference between these two numbers to calculate net income. In this case if you have $56,000 revenue and $36,500 expenses then your net income must be $19,500 since net income is calculated by subtracting expenses from revenue. After recording the $19,500 on the income statement, we must report the net income on the statement of retained earnings. Using the balance sheet, we are able to calculate retained earnings. For the balance sheet we have $91,000 debits and $73,500. The difference between these two numbers is retained earnings of $17,500 which gets recorded as a credit on the balance sheet. The difference of $2,000 between retained earnings and net income is the result of the company paying out $2,000 in dividends. Overall what happened was that the company generated $19,500 net income, paid $2,000 and retained $17,500 within the company in the form of retained earnings. The net income and retained earnings are calculated during the closing process.
4.11 - Standardization of Accounting Principles
Essential to financial accounting is for the need to make financial statements comparable to other company's financial statements. To accomplish this goal, accounting professionals, businesses and other organizations have collaborated to create a uniform set of accounting standards.
Generally Accepted Accounting Principles (GAAP)
Generally accepted accounting principles (GAAP) are the set of accounting standards for financial accounting used in any given jurisdiction. These standards include conventions, and rules that accountants follow in recording and summarizing financial transactions. In the United States, the most common reporting basis is called US GAAP. US GAAP is created by the Financial Accounting Standards Board (FASB). In 1973, the FASB created the financial accounting conceptual framework which provides guidance in terms of how financial accounting should be practiced. The FASB has also worked to simplify accounting research and allow for easier searching of accounting standards with the creation of the US GAAP Codification®. The US GAAP Codification is considered “the single source of authoritative nongovernmental U.S. generally accepted accounting principles” by the FASB.
The US Securities and Exchange Commission (SEC), a government organization charged with ensuring enforcement of securities laws for publicly traded companies, also has the power to create accounting regulations. However, the SEC has set a precedent by allowing the FASB and accounting professionals to determine proper accounting treatment of transactions. The SEC is still able to issue specific requirements for publicly traded companies (companies that trade on stock exchanges where the general public can buy and sell stock) and enforce those requirements. In the United States, the SEC requires publicly traded companies to issue an annual report called a 10k. The 10k is to be audited by an independent public accounting firm. Another requirement for SEC reporting companies is to issue quarterly financial statements called the 10Q. 10Q financial statement do not have to be audited by a public accounting firm due to the need to report timely financial information.
International Financial Reporting Standards (IFRS) The vast majority of countries in the world use International Financial Reporting Standards (IFRS) to report their financial statements. Similar to US GAAP, IFRS also has a central standard setting body which is called the International Accounting Standards Board (IASB). Over the past 30 years, the world has increased its level of global trade and many companies now operate as multinational corporations. Investors have often found it difficult to invest aboard due to the differences between GAAP and IFRS. Due to this issue, the FASB and IASB have teamed up to work on converging the two set of reporting frameworks. Every year, the differences between GAAP and IFRS are resolved and a common set of rules is used between both frameworks. The differences between GAAP and IFRS are minor and it is recommended that students learn how to report transactions using both frameworks when taking intermediate accounting courses. Eventually both frameworks will be completely converged and there will be no need to learn two sets of frameworks.
Other Reporting Frameworks
Many countries and governments in the United States choose to “opt out” of GAAP practices for a variety of reasons. In government accounting, the primary purpose of financial reporting to provide accountability of taxpayer funds. This often means that government accounting is performed using a cash basis rather than an accrual basis. Another major accounting framework is tax basis which is used by many tax authorities. When you prepare a federal income tax return in the United States, you must prepare your accounting records according to tax basis. Accrual basis financial data must be converted to a modified cash basis based on the tax authorities' guidelines.
4.12 - Extensible Business Reporting Language (XBRL)
Extensible Business Reporting Language (XBRL) is a technology which helps to facilitate the exchange of business information. XBRL allows information to be exchanged that includes semantic meaning for the data being presented. Semantics means the underlying meaning of the information. For example, I could say that a company has $35,000. Without any additional information we have no idea what the $35,000 means. It could mean cash, property plant and equipment, net income or a variety of other aspects of the business. With XBRL technology, the underlying meaning can be encoded into the document to provide this extra level of meaning. For example, I could encode into the data that the $35,000 is $35,000 of current assets.
XBRL is based on extensible markup language (XML). XML is a way to allow documents to be created that are both human readable and machine readable. Having the documents being machine readable is important because it would allow for data analysis of financial documents on larger scales. For example, as more companies move to producing XBRL financial reports it will allow computers to analyze all of these documents and provide additional information. It would also allow individual users to extract or create custom reports using a large set of XBRL documents. Without the use of computers, producing these reports would be extremely time consuming.
In recent years, large securities regulators, such as, the securities and exchange commission have begun requiring companies to produce XBRL financial reports and other documents.
Learning XBRL coding is relatively simple as the whole technology is standards based and free to use. XBRL is taught in detail in specific courses on the topic or in accounting information systems courses.
4.13 - Financial Reporting Process
The financial reporting process is the formal process by which a company reports their financial condition to users of financial statements. In addition to reporting their financial statements and notes to the financial statements most companies are required to comply with additional reporting requirements. For publicly traded companies, these additional requirements are federal, state and local securities laws. The primary requirements are mandated by the federal government's securities and exchange commission (United States). Additional requirements might be imposed by foreign governments.
The best way to demonstrate the financial reporting process is by using an example. In our example we will review an annual report from the Coca-Cola company. The annual report must comply with the United States federal securities laws of 1934 and is reported using form 10-k. Below we can see page one of the forms filed by the Coca-Cola Company.
The entire 2017 10-k can be found at this link. The entire document is 170 pages long. We will review the table of contents to give an overall feel of how the financial reporting process works.
- Forward-looking statements: This is an SEC mandated disclaimer stating that the report can contain comments about the future performance of the company. The disclaimer warns users of the financial statements that the performance of the company can change in the future.
- Part 1 - Item 1 - Business: A description of what the company sells and the overall nature of their business. In this case, the Coca-Cola company is in the business of selling beverages.
- Part 1 - Item 1A - Risk Factors: The company lists the risk factors that could negatively impact their business. In this case, the company lists many risk factors with a few of the risks being increased competition, risk of compromise of critical infrastructure and rising interest rates.
- Part 1 - Item 1B - Unresolved Staff Comments: If the SEC had any comments related to the report they would be listed in this section. In this case, the company had no unresolved staff comments.
- Part 1 - Item 2 - Properties: Lists the most important physical locations for the company, such as, headquarters, warehouses, mines etc.
- Part 1 - Item 3 - Legal Proceedings: Lists significant pending lawsuits or other legal matters that are other than ordinary.
- Part 1 - Item 4 - Mine Safety Disclosures: Lists safety disclosures that are required by mining companies.
- Part 1 - Item X - Executive Officers of the Company: Lists information about the key executives of the company.
- Part 2 - Item 5 - Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities: List information about the company's composition of shares and related information such as dividends, share repurchases etc.
- Part 2 - Item 6 - Selected Financial Data: Lists select financial information that spans the last five years.
- Part 2 - Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations: The managers of the company give their opinion about business performance, operations and technical analysis.
- Part 2 - Item 7A - Quantitative and Qualitative Disclosures about Market Risk: Discusses the company's risk to market risk such as interest rate changes, foreign currency exchange and commodity price changes.
- Part 2 - Item 8 - Financial Statements and Supplementary Data: Contains the company's financial statements and related notes. A full set of financial statements is required: the balance sheet, income statement, statement of cash flows and statement of stockholder's equity.
- Part 2 - Item 9 - Changes in and Disagreements with Accountants on Accounting and Financial Disclosure: If the company changed auditing firms then the company must disclose any disagreements they had with the previous firm.
- Part 2 - Item 9A - Controls and Procedures: Discusses the company's internal controls over financial reporting and operations.
- Part 2 - Item 9B - Other Information: Discloses other information that was reported on other forms but was not reported directly in the 10-k.
- Part 3 - Item 10 - Directors, Executive Officers and Corporate Governance: Discusses the executive team, the code of ethics, and the background of each executive.
- Part 3 - Item 11 - Executive Compensation: Lists how the top executives are compensated for the year.
- Part 3 - Item 12 - Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters: Discloses share ownership by the executives and other large shareholders.
- Part 3 - Item 13 - Certain Relationships and Related Transactions, and Director Independence: Contains information about financial arrangements or transactions that have occurred between the company and the executive team or top managers.
- Part 3 - Item 14 - Principal Accountant Fees and Services: Lists how much the auditing firm was paid and also lists other services that were performed and how much was paid for the service.
- Part 4 - Item 15 - Exhibits, Financial Statement Schedules: Lists the financial statements that were included with the 10-k as well as any supporting schedules that include important information, such as, significant contracts.
- Part 4 - Item 16 - Form 10-k Summary: Summarizes the 10-k followed by the signatures of the auditing firm and executive management.
That essentially summarizes what is contained in a 10-k. It is recommended to review a real 10-k to see how it is written and structured. Click here to read the Coca-Cola 10-k
4.14 - The Role of Financial Statement Auditors
The SEC requires publicly traded companies (companies whose stock is traded on public stock exchanges) to have an annual audit of their financial statements and financial reports. The external auditor is required to be independent from the company to prevent bias, however, the firm pays the external auditor for performing the audit service. After the audit has been performed, the external auditor will issue an audit report which state's the auditor's opinion about if the company has complied with a specific set of accounting standards. An audit of the financial statements is generally comprehensive in the sense that the auditors will test the entire accounting system to determine how well the company has been complying with the accounting standards.
The audit begins with the auditor testing the internal controls of the accounting system to determine how well the system records transnational data. More evidence is gathered by performing analytical procedures and substantive procedures designed to detect if any material misstatement exist in the financial reports. A material misstatement is a significant error that would cause the financial statement users to change their opinion of the company. The auditor will also evaluate the management team to determine if any significant weaknesses exist in how they make judgements in terms of accounting estimates. The audit concludes with the auditor stating their opinion of how well the firm has complied with the accounting standards.
Within the United States, the Public Company Accounting Oversight Board (PCAOB) is responsible for regulating and evaluating independent auditing firms that audit public companies (companies that list stock or debt securities on public exchanges). The PCAOB was created as a result of the Sarbanes-Oxley Act of 2002 which is commonly referred to as SOX. The Sarbanes Oxley Act was created as a result of several large-scale accounting frauds that occurred at Enron and WorldCom in 2001 and 2002 respectively. The PCAOB will audit independent auditing firms to determine if they are performing quality audits and following PCAOB regulations. An auditing firm that audits public companies must register with the PCAOB and agree to having periodic audits done by the PCAOB. The PCAOB requires auditing firms to have a quality control system. PCAOB registered auditing firms are also required to issue an opinion on the public company's internal control system over financial reporting.